Audit scope: we need a Court case to sound a wake-up call

The relevance of any set of accounts obviously wanes as time passes. Vast, complex multinational conglomerates, required by law and market expectations to present published financial statements within strict deadlines, can manage this process if well-governed, but auditing those statements within the same time frame can present even the largest audit firms with serious logistical difficulties.

If time were not a limiting factor auditors could simply beaver away until confident that every material entry has been authenticated. But by then the accounts, attracting full marks for reliability, would be so out of date as to be worthless for any practical purpose – and the cost could bankrupt the client!

the sheer size of the job leaves firms with little option but to consolidate resources

Regulators have wrestled with this issue for decades. They simplistically conclude that the reduction to only four major audit firms offends competition law, not recognising that the sheer size of the job leaves firms with little option but to consolidate resources through mergers. The fraught alternative is to compromise on standards, or worse. Indeed, the path from “Big 8” to “Big 4” involved casualties, including Arthur Young, ill-fated auditors of Johnson Matthey Bankers in the ‘80s, and Arthur Andersen, auditors of Enron and WorldCom 10 years ago.

So how does an external audit firm determine a convincing audit scope that places a reasonable measure of reliance on the client’s own systems and records without compromising investigative rigour, critical analysis and independent judgement?

What, exactly, are they auditing?

Cases in which scope determination manifestly failed to cover the very issues that bring a company down have been insufficiently tested in our Courts. Corporate detritus litters the wake of the banking crisis, with billions of pounds of losses to investors. Yet auditors blithely reject all suggestions of culpability with the flimsy contention that their scope did not “require” them to investigate the sustainability of the client’s business model – even when, as with Bradford & Bingley and Northern Rock, it was obvious that a house-price reversal would freeze their liquidity and convert the same business model into a recipe for instant annihilation.

Did the auditors’ own assumptions include a belief that property prices could go only up? If so, they gave themselves no reason to open up and look at even one tranche of the sanitized mortgages on which the entire superstructure of derivative dross was based.

If the excuse for such dereliction was the absence of any explicit requirement in the Standards, why didn’t the overriding statutory “true and fair” imprimatur supervene? It seems that only a seminal and salutary finding in the courts will awaken our profession and re-assert its raison d’être.

In the USA judges have got the message and ruled that technical compliance is subordinate to the ultimate statutory goals of fairness and accuracy in financial reporting. Merely avoiding a breach does not, of itself, give any assurance, particularly when at least some of the accounting dogma borders on the insane, such as the marking-to-market of bond liabilities and then balancing the entry by increasing earnings.

Reliance on management representations, despite the probability that those representations flatter performance without any tested foundation, makes a mockery of the notion of independent judgement. This remains the most regularly cited criticism of audit work, and the most regularly cited cause of actual audit failure.